Paul Meloan – Vested Interest

With year-end approaching, we occasionally need to remind our retired clients to take the required minimum distributions from their retirement plans such as an IRA or 401(k) account.

By the time most people are into middle-age they understand the basics of tax-qualified retirement plans. You contribute money during your working life (usually pre-tax) and invest it. The asset’s growth is never taxed, but rather any distribution from the account is taxable income. With some limited exceptions this doesn’t happen until the account holder is retired and at least 59 and 1/2 years old.

But what if the retiree doesn’t need the money? What if they would rather not take it out from their 401k or IRA? In most cases, there’s a problem with that.

What are the rules?

The tax code (in it’s usual arcane way) spells out a number of rules designed to make sure that retirees don’t get to leave the money in the account forever. In some cases, there are nasty tax penalties for ignoring these rules. Generally, a person needs to begin taking money out from a qualified retirement plan in the year which she turns 70 1/2. Why 70 1/2? I have no idea. If a camel is a horse designed by a committee then a tax rule is a painting made by color-blind people.

Each year after that, the account holder must withdraw an amount specified by a formula in a table published by the IRS. In essence, you must withdraw a larger percentage of the account each year to make the account unwind over the rest of your life. The balance subject to distribution is whatever the account was worth on December 31 of the previous year.

Show me an example.

For a basic example, my client Harry has an IRA with a value on 12/31/2018 of $500,000.  Harry turned 76 in 2019, and the age factor for people turning 76 is 22.0.  That means I take Harry’s 2018 balance and divide it by 22.0, which yields a result of $22,727.27.  Harry must withdraw that amount on or before 12/31/2019 and that amount goes into his 2019 tax return as ordinary income.

Of course, there are another 100 rules about how to work through these calculations that are of particular interest to people with multiple retirement accounts. It is not unusual for me to encounter new clients that may have multiple IRAs or 401(k) plans all over the landscape.  Many of these rules are contained in IRS Publication 590-A.  Other rules about individual retirement plans can be found in IRS Publication 560.

Important: Roth IRAs are NOT subject to minimum distribution requirements. This is but one of the many reasons we love them for our clients and for ourselves.

How have recent updates changed the tax code?

With the overhaul of the tax rules beginning in 2018, there is an important opportunity buried inside IRAs that are subject to these distribution requirements. It is now possible to make charitable contributions directly from an IRA. A person age 70 or over can make up to $100,000 in direct gifts each year from her IRA.

In my example above, Harry has almost $23,000 of income going on his tax return. If he itemizes his deductions and made $23,000 of gifts to charity that year, the tax is effectively wiped out. But if Harry is married, he and his wife already get a $24,400 standard deduction on their taxes anyway. If they do not have a mortgage (mortgage interest is still deductible) it his highly unlikely that this gift will give them any tax benefit at all.

But what about Harry?

There’s a solution to this in the new code. Harry and his wife make up to $23,000 of charitable gifts directly from their IRAs. They will have both satisfied the required minimum distribution requirements but no income is reported on their tax return. They can still take the standard deduction on their tax return as well. If you or someone in your family is (1) over 70; (2) is making required minimum distributions from a retirement plan; and (3) wants to give money to charity it’s important to understand what this is and how it works.

Finally, when a retired person dies with money remaining in a retirement plan that money goes to the designated beneficiary. In many cases that is the surviving spouse. If there is no spouse there are required distributions from the plan each year to the beneficiary. The rules on these make the ones above look simple, so it’s important to understand exactly how much needs to be withdrawn each year.

Paul Meloan is the co-founder and co-managing member of Aegis Wealth Management, LLC, in Bethesda, Maryland USA. Before Aegis Paul was a practicing attorney as well as working in the tax practice of Ernst & Young, LLP.

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